DeltaNeutralCalendarSpreading

</noinclude>Delta Neutral Calendar Spreading by Rob Chalupa
So you are an investor that would like to invest in the stock market, and you want to make a profit but you do not want to lose your primary capital. In the spirit that a doctor is taught to “first do no harm”, the scope of this article is to propose one idea that presents a low risk but high reward strategy.
First let me clarify that no options strategy is without risk. The primary risks associated with this strategy are volatility dropping and a large move in the underlying.
As of April 2011, two hot investments are oil and energy. Let me make a supposition that a trader places $1,000 in the stock of USO and $1,000 in the ETF XLE. Now let us assume XLE drops 25% and USO drops 25%. This will result in a 25% capital loss of the initial $2,000 = a $500 loss. Let us use this as a benchmark.
To fight against the volatility drop risk, one method is to not invest in calendar spreads where both front and back month are already on the high side. The second method in which I attempt to offer a strategy is to buy a percent of your calendar spreads over time while neutralizing delta risk. This approach will not entail dramatically higher commissions, and will neutralize delta risk, and will protect you from paying too much all at once up front for the initial calendar spreads. As an example, you will find it all too familiar if you paid $100 per calendar spread today, and 7 days later find the same spread to be $90. If you bought 5 today for $100 and five one week later for $90, your average cost is $95.
Let us take a real world example of USO as of April 2011. To enter the initial delta neutral spread, you will take a one sigma move delta calculation against USO. The underlying asset is currently at $41. A one sigma move based on the historical volatility of 25% is (41 * .25% / 2) 5 41-5 = 36. The fundamental idea is to sell a 36 put, buy a 36 put in a forward month. Sell a 46 call and buy a 46 call in a further month. What we have done is created a double calendar spread that is delta neutral. The dual spread may be profitable if the underlying stays between 36 and 46 by expiration.
Adjustments to the position:
Each week, we will calculate the delta of the position. If it is negative (the position would prefer the market to drop), we need to buy a few more calendar spreads on the bullish side. If it is positive (the position would like the market to rise), we should buy some calendars on the bearish side. This will neutralize the deltas and increase our theta, and dollar cost average our cost of the entire position.
My personal technique is to close out calendar spreads that have close to zero hedge remaining on the short leg. You may use this technique in tandem with opening new spreads. I recommend closing out an entire time series at the same time when you feel there is a risk of the long legs decaying, and simply start over with new calendar spreads in the next time series.
With this delta neutral technique, you take away most of the risk with the underlying wildly swinging each day. My goal is to give you an idea of how you can preserve your primary capital if the UL moves wildly in either direction.
Let us compare calendar spreading to owning the stock outright. Usually during a wild swing, volatility increases. If you monitor the position, and find the market is coming close to breaching the low or high side of the calendar, you will most likely be able to close the whole position for a profit since volatility is increasing.
Compare that to what happens if USO or XLE are down 20% and you own the stock. If you decide to take a capital loss, your primary capital has been reduced by 20%.
Over time, my experience with calendar spreads has been that you may lose 10% when volatility is dropping, but with positive theta (time on your side) nature of the spreads, you also will make up for the 10% loss when volatility is rising.
Good luck with your calendar spreading!

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